Bond Market Says Interest Rates Could Go Higher

If there’s one thing investors should watch these days, it’s interest rates. More specifically, they should pay attention to bond yields.

Since the beginning of the COVID-19 pandemic, the Federal Reserve has said it would do whatever it takes to keep interest rates low. In the early part of 2020, the central bank dropped its benchmark interest rate to zero and promised to print extreme sums of money to keep rates low.

Why would the Fed do this? Because of the belief that, in times of economic slowdown, the Fed lowering interest rates will increase borrowing, and this, in turn, will have impacts across the economy. Also, the Fed lowering its benchmark rate and printing money essentially makes sure there’s liquidity in the financial system.

But here’s the thing: bond yields continue to soar, which is the opposite of what the Fed wants. Look at the chart below. It plots the yield on 10-year U.S. bonds.

Chart courtesy of Stockcharts.com

In August, yields on 10-year U.S. bonds hit a record low—around 0.53%. But since then, bond yields have surged a bit. They currently stand at 0.92% (up 75% from the low), and the trend is pointing upward.

Why Does It All Matter?

One must really question why this is happening, and whether it could have impacts on the overall economy.

You see, bond yield is essentially one of the biggest deciding factors on what kind of interest rates Americans will get charged on things like mortgages and car loans.

So, if bond yields soar, we could see mortgage rates increase all of a sudden. Currently, the 30-year fixed-rate mortgage is 2.7%, a record low, and this has caused the U.S. housing market to get hot in certain areas. Rising yields could impact mortgage rates, and this could cool down the housing market and even lower home prices.

But there’s something bigger that needs to be addressed here: the derivatives market.

In simple words, derivatives are contracts between two parties over a certain asset. Derivatives prices move with the price of the asset that the contracts are based on. For instance, if a trader buys derivatives betting that interest rates will go down and that doesn’t happen, the trader will lose money. The other party who took the opposite side of the contract will make money.

As per the most recent data, major U.S. banks held derivatives contracts with a notional value of $129.8 trillion that had direct exposure to interest rates. (Source: “Quarterly Report on Bank Trading and Derivatives Activities: Third Quarter 2020,” Office of the Comptroller of the Currency, last accessed December 23, 2020.)

Dear reader, this is a big amount. Just imagine if five percent to 10% of these derivatives went bad and a major bank was on the wrong side of the trade, betting that interest rates would drop further. It could create a big problem. In fact, a financial crisis could be at hand in no time.

I continue to watch bond yields closely; ultimately they tell me what’s happening with interest rates. An average investor may think that the yields don’t matter, but they do. If there are wild fluctuations, it could create volatility in the stock market.

Be careful.